For the past several years, the rate of inflation has been near 2 percent—one-third lower than the 3 percent historic average inflation rate. Now, as the economy continues to stabilize and the Federal Reserve begins to taper its economic stimulus efforts, some experts expect inflation rates to increase. 1 What will this mean for you and your finances?
Will you be affected?
The short answer is yes. “Everyone is affected by inflation,” says Steven Weisman, a senior lecturer of law, taxation and financial planning at Bentley University.
Weisman notes that individuals who depend on a fixed income, like many retirees, will feel the effects of inflation the most. “Inflation eats into the value of your assets,” he says. “As the cost of things goes up, you’ll see the return on your investments going down.”
Even low levels of inflation can have a major impact on your finances over time. Let’s say your cost of living now is $50,000 a year. With a 3 percent annual inflation rate, in 20 years you’ll need $90,306 to fund the same standard of living.
What you can do about it
While inflation is something we all have to accept, making a smart investment plan now can help you prepare for future rising prices. “The challenge is finding investments with a rate of return that will keep up with inflation,” Weisman says.
The majority of savings accounts currently offer less than 1 percent interest. This means that over time, that money is going to lose value. Other options, such as inflation-linked certificates of deposit or inflation-adjusted government bonds, offer protection from inflation with minimal risk. While these options offer some security, they are unlikely to offer much growth over the long term.
Aim for growth
One of the best things you can do to combat inflation is to diversify your portfolio with an array of stocks or stock mutual funds. The reason: Stocks are the only asset class that has beaten inflation in every rolling 20-year period since 1926.2
This track record is worth considering, even for those nearing or in retirement. The traditional rule of thumb is that the older you are, the more you should allocate assets to bonds and cash to protect against stock market volatility. However, keeping a portion of your portfolio in well-chosen stocks that offer growth potential is a great way to protect against inflation.
Retirement can last more than 30 years and you’ll need your portfolio to continue to grow over that time. Ultimately, you’ll want to build a balanced portfolio that grows faster than inflation so you can fund your living expenses—now and in the decades ahead.